Firstly, what are futures and options?
Futures and Options are known as derivatives as they derive their value from an underlying asset. F&Os are enforceable contracts between market participants who undertake to trade in company stocks or market indices at the pre-decided price sometime in the future. In India, F&O trading is done on a list of stocks stipulated by SEBI, and this list is updated regularly. So, the eligible F&O stocks keep changing.
F&O trading in India
F&O trading is also done for commodities and currency. Currently, there are nearly 200 stocks in which F&O trading is allowed. Apart from this, Futures and Options trading is also available for certain Indexes – the most popular instruments being Nifty and Bank Nifty.
The emerging derivative trading market
Futures and Options are popular tools for traders, especially the short-term ones, in the stock market today. Gradually, derivatives have found their way into the modern financial markets. Today, derivatives are used by traders for speculation and hedging.
And this popularity of the derivatives market has enabled the NSE to retain its title of the largest global derivatives trading market for the third time in a row.
Why do we need derivative trading strategies?
The markets are unpredictable. To enter into uncovered or unhedged positions would be like running towards the fire. On the other hand, derivative trading strategies help quantity the financial results of execution beforehand, thus bringing consistency and objectivity to the trade.
5 crucial things you must know before trading in F&O
As compared to cash trading, F&O have varied characteristics. If you are keen to take up F&O trading, it would be helpful to be aware of the following points:
1) F&O trading offers extreme leverage and liquidity
One of the leading reasons for the popularity of Options Trading in India is the leverage accorded in these trades – traders can take up positions for a fraction of the actual cost generally involved. Also, exiting positions is convenient as the large trading volume keeps the liquidity intact.
So, for example, to buy a Futures contract of Reliance Ltd., which has a lot size of 250 shares, one would need a margin of about Rs. 1.5 lakhs. Whereas, if you had to buy 250 shares of Reliance at the current market price, the investment would be roughly Rs. 6.4 lakhs.
In the case of Options, to buy one lot of Reliance shares at the strike closest to CMP, depending on expiry, would require a margin of money of only about Rs. 25,000.
2) F&O can be used to take long or short positions
Whether you are bullish or bearish on future trends, futures and options have tools for you. So if you are confident of an uptrend, you could buy a Futures contract or buy a Call Option or sell a Put. Similarly, short positions can be taken up by selling a Futures contract, buying a Put Option or selling a Call Option. Derivatives are the easiest way to short in Indian markets.
3) F&O trades come with an expiry date
Unlike cash trades, where you can buy a stock and hold it for a long duration, derivatives come with a fixed expiry date. In the case of Options, stocks have a monthly expiry date which falls on the last Thursday of the month. In the case of Index Options, expiries are available for weekly and monthly contracts.
4) F&O trading has lower transaction costs
With the emergence of Options Trading App, F&O trading has become very economical in transaction costs. Mainly brokers offer trading services at Rs. 20 per order. Some also offer zero brokerage in case of intraday trading for F&O – F&O pricing is dependent on the underlying asset.
But remember, not everything cheap is worth the buy. You might lose the entire principal if the strategy is not well-researched and the sole motive of the purchase is affordability. It would be best to consider other factors like liquidity advantage and profit probabilities while taking a market position.
5) Price of F&O contracts depends on the underlying asset’s price
Traders need to note that prices in F&O trades are not independent. The F&O pricing also moves in tandem depending on the stock or index’s price movement. For Options, the price is determined by intrinsic and extrinsic values. IV measures the Options worth concerning the market value of the underlying. EV is based on the time left for expiry.
F&O trades are taken up today via online trading with a few buttons. Balancing all factors, a trader should enter into F&O positions with complete knowledge and tested strategies. But traders need to realise that the leverage offered to buy F&O trading can cut both ways. It can give superior returns on a good trade while creating losses for a bad trade.